The Treasury Department and the IRS recently issued final regulations under Internal Revenue Code Section 409A (“409A”), the landmark provision that marked a major change in the tax treatment of certain deferred compensation plans. The final regulations, issued on April 10, 2007, provide definitive guidance on the taxation of nonqualified deferred compensation and amounts includable in income under 409A. The final regulations contain limited transition periods expiring at the end of 2007 and other guidance that will have an immediate impact on employers, from major corporations to small enterprises. This article describes the significant clarifications and changes in the final regulations from the proposed regulations and other prior guidance released under 409A, including Notice 2005-1.

For detailed discussions of 409A and the prior guidance issued under 409A, please see the October 2004, January 2005, November 2005, December 2005,

January 2006 and December 2006 issues of the White & Case llp Executive Compensation, Benefits and Employment Law Focus.

Summary of 409A

409A provides that all amounts deferred under a nonqualified deferred compensation plan are included in income when deferred (or, if later, when the amounts are no longer subject to a substantial risk of forfeiture) unless certain requirements established by 409A are satisfied. The requirements include rules regarding the timing of deferral and distribution elections and permissible distribution events. Generally, a distribution can be made upon an employee’s separation from service, disability, death, a specified time, a change in ownership or effective control, or in the ownership of a substantial portion of the assets, of a corporation (or partnership) or an unforeseeable emergency. If an amount of deferred compensation is required to be included in income under 409A, that amount is subject to ordinary income tax, plus an additional 20 percent income tax and interest may be assessed on tax underpayments in certain circumstances. 409A is applicable to (i) amounts deferred in taxable years beginning after December 31, 2004, and (ii) amounts deferred in taxable years beginning before January 1, 2005, if the plan under which the deferral is made was materially modified after October 3, 2004.

Effective Date of the Final Regulations

The final regulations will not become effective until January 1, 2008. A nonqualified deferred compensation plan subject to 409A will not be treated as violating 409A on or before December 31, 2007 if the plan is operated in reasonable, good-faith compliance with 409A and the plan is amended on or before December 31, 2007 to conform to the provisions of 409A and the final regulations. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should operate the plans in reasonable, good-faith compliance with 409A at all times and prepare to bring the plans into full administrative compliance with 409A by December 31, 2007. Compliance with the proposed regulations or the final regulations before 2008 is not required but constitutes reasonable, good-faith compliance with 409A (even to the extent that the proposed regulations or final regulations conflict with each other or with Notice 2005-1).

Identification of Plans Subject to 409A

Generally. 409A applies to nonqualified deferred compensation plans, which are plans and arrangements that provide for the deferral of compensation, other than tax-qualified plans and plans that provide vacation leave, sick leave, compensatory time, disability pay or death benefits. A plan provides for deferral of an employee’s compensation if, under the plan, and the relevant facts and circumstances, the employee has a legally binding right during a taxable year to compensation that is or may be payable to the employee in a later taxable year.

Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations change the definition of deferral of compensation to eliminate the requirement that amounts not be actually or constructively received and included in gross income. This change avoids confusion regarding the rules governing deferral elections and the prohibition on the acceleration of payments. For example, if an employee has made an irrevocable election to defer a portion of his 2008 salary until 2010, the amount is treated as deferred compensation regardless of whether the employer actually pays such amount to the employee

in 2008 (i.e., the payment of the salary in 2008 is an impermissible accelerated payment of deferred compensation, even though the employee receives and includes the salary in income in 2008). n The final regulations contain a general anti-abuse provision to address plans that contravene the purposes of 409A. Specifically, the final regulations clarify that if the principal purpose of a plan is to achieve a result with respect to a deferral of compensation that is inconsistent with the purposes of 409A, the IRS may treat the plan as a nonqualified deferred compensation plan that is subject to 409A.

Service Providers. Though we use the terms “employer” and “employee” throughout this article for the sake of simplicity, 409A generally applies to all service providers, including outside directors, independent contractors and personal service corporations.

Noted Changes/Clarifications from Proposed Regulations:

  • 409A does not apply to amounts deferred by independent contractors that provide significant services to two or more clients that are not related to each other or the independent contractor.

The final regulations expand the circumstances under which contractors who are related to one or more of their clients may still take advantage of this exception.

Short-Term Deferrals. Even if a plan falls within the general definition of a nonqualified deferred compensation plan, it may meet one of several specified exceptions that will bring the plan outside the scope of 409A. A deferral of compensation does not occur if the plan under which the payment is made does not provide for a deferred payment and the compensation is paid, within two and a half months after the later of (i) the end of the employee’s first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture or (ii) the end of the employer’s first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture.

Noted Changes/Clarifications from Proposed Regulations:

n The final regulations clarify that the short-term deferral exception may only apply to payments made under a plan that does not otherwise provide for a deferral of the payment. A plan provides for a deferred payment if the plan provides that the payment will be made or completed upon any date or event that will or may occur after the 2½-month period mentioned above. For example, if a plan provides that a payment will be made upon an event, such as a change in control or separation from service that may occur during or after the applicable 2½-month short-term deferral period, the short-term deferral exception will not be available.

  • If the taxpayer establishes that it was administratively impracticable (and that such impracticability was unforeseeable), or would have jeopardized the ability of the employer to continue as a going concern, to make a payment that would otherwise be a short-term deferral within the required time period, the payment will still qualify for the short-term deferral exception if it is paid as soon as administratively practicable or when the payment would not have that effect.
  • Delays in payment are also permitted to avoid the unanticipated application of Section 162(m) of the Internal Revenue Code (the $1 million annual cap on deductible compensation for certain employees of publicly held corporations), provided that the payment must be made as soon as reasonably practicable following the date in which the employer reasonably anticipates that the deduction will not be restricted by Section 162(m).

Plan Aggregation. All plans in which an employee defers compensation that fall within the same category, as described below, are aggregated for certain purposes under 409A, including initial participation determinations, plan terminations and income inclusion upon a 409A violation.

Noted Changes/Clarifications from Proposed Regulations:

n The proposed regulations added several additional categories of plans that are aggregated for purposes of the 409A rules. The addition of these categories is favorable to taxpayers and potentially reduces the impact of 409A violations on other plans. The categories of plans that are aggregated for certain purposes under 409A are

as follows:

(i) account balance plans at the election of the employee,

(ii) account balance plans not at the election of the employee,

(iii) non-account balance plans,

(iv) separation pay arrangements providing benefits under a “window program” or upon involuntary separation from service,

(v) in-kind benefits or reimbursements of expenses that do not constitute a substantial portion of the employee’s compensation for services or separation,

(vi) split-dollar life insurance arrangements,

(vii) certain amounts deferred under foreign plans,

(viii) stock rights and (ix) all other plans.

Grandfathered Plans.

Generally, amounts deferred and vested in taxable years beginning before January 1, 2005 (as well as earnings on these amounts), commonly referred to as grandfathered amounts, are not subject to 409A as long as the plan under which the amounts are deferred is not materially modified after October 3, 2004. Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations clarify that certain amendments and modifications will not be material modifications to an otherwise grandfathered plan, including: modifications to comply with domestic relations orders; modifications to permit employees to elect between an existing life annuity and another actuarially equivalent annuity payment; and modifications to required cash outs of account balances that are less than the Section 402(g) limit ($15,500 in 2007).
  • In addition, a provision of a grandfathered plan requiring cancellation of deferrals for a prescribed period of time in order to receive a distribution from such plan may be modified to provide that deferral elections will be cancelled for the equivalent period of time beginning with the first date that such cancellation will not result in prohibited acceleration of payment (generally the beginning of the subsequent calendar year). For example, where an employee receives a distribution under a grandfathered plan that requires immediate cancellation of all deferrals for a period of one year in order to receive such distribution, but the employee has outstanding deferral elections under a plan subject to 409A (and cancellation of the deferral election would cause a violation of 409A), the grandfathered plan may be amended to provide that the cancellation of deferrals will be required for a period of one year beginning on the first day of the calendar year following the distribution.

Documentary Compliance

All nonqualified deferred compensation plans that are not grandfathered will need to be put in writing and amended to comply with 409A by December 31, 2007. Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations clarify that nonqualified deferred compensation plans should, among other things,

(i) set forth permissible timing requirements for deferral elections,

(ii) set forth permissible requirements for subsequent elections to extend deferral periods or otherwise change payment elections,

(iii) not permit prohibited accelerations of payments (although the plan is not required to affirmatively set forth the permitted exceptions to the anti-acceleration rule), and

(iv) if applicable, set forth the required six-month delay in payment to specified employees.

  • The preamble to the final regulations clarifies that the use of a “savings” clause (such as a clause which states “regardless of any inconsistent provision, this plan shall be interpreted in accordance with 409A”), will not be effective for purposes of 409A compliance.
  • The final regulations clarify that the material terms of a plan may be set forth in more than one document.
  • Plans are not required to be amended to document the plan’s compliance with 409A for periods before the effective date of the final regulations, provided that the plan has otherwise been operated in compliance with applicable transitional guidance under 409A.

Deferral Elections

Elections to defer compensation to a later date must, generally, be made before the close of the tax year preceding the year during which the compensation is earned.

Noted Changes/Clarifications from Proposed Regulations:

  • A plan that does not permit employees to elect the time and form of payments must specify the time and form of payment no later than the later of (i) the time the employee first has a legally binding right to the payment and (ii) the time the employee would have had to make an irrevocable deferral election, had such election been available to the employee. For example, in the case of an employer who, on December 15, 2007, grants an employee a bonus in respect of services to be performed in 2008 that may not be reduced or eliminated in the unfettered discretion of the employer and that is payable at a later date (but not at a time when such payment would qualify as a short-term deferral), the employer must establish the time and form of payment on or before December 31, 2007 (i.e., the date on which the employee could have made the election to defer the bonus). Then In addition, a provision of a grandfathered plan requiring cancellation of deferrals for a prescribed period of time in order to receive a distribution from such plan may be modified to provide that deferral elections will be cancelled for the equivalent period of time beginning with the first date that such cancellation will not result in prohibited acceleration of payment (generally the beginning of the subsequent calendar year). For example, where an employee receives a distribution under a grandfathered plan that requires immediate cancellation of all deferrals for a period of one year in order to receive such distribution, but the employee has outstanding deferral elections under a plan subject to 409A (and cancellation of the deferral election would cause a violation of 409A), the grandfathered plan may be amended to provide that the cancellation of deferrals will be required for a period of one year beginning on the first day of the calendar year following the distribution.

Documentary Compliance

All nonqualified deferred compensation plans that are not grandfathered will need to be put in writing and amended to comply with 409A by December 31, 2007. Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations clarify that nonqualified deferred compensation plans should, among other things,

(i) set forth permissible timing requirements for deferral elections,

(ii) set forth permissible requirements for subsequent elections to extend deferral periods or otherwise change payment elections,

(iii) not permit prohibited accelerations of payments (although the plan is not required to affirmatively set forth the permitted exceptions to the anti-acceleration rule), and

(iv) if applicable, set forth the required six-month delay in payment to specified employees.

n The preamble to the final regulations clarifies that the use of a “savings” clause (such as a clause which states “regardless of any inconsistent provision, this plan shall be interpreted in accordance with 409A”), will not be effective for purposes of 409A compliance.

  • The final regulations clarify that the material terms of a plan may be set forth in more than one document.
  • Plans are not required to be amended to document the plan’s compliance with 409A for periods before the effective date of the final regulations, provided that the plan has otherwise been operated in compliance with applicable transitional guidance under 409A.

Deferral Elections

Elections to defer compensation to a later date must, generally, be made before the close of the tax year preceding the year during which the compensation is earned.

Noted Changes/Clarifications from Proposed Regulations:

  • A plan that does not permit employees to elect the time and form of payments must specify the time and form of payment no later than the later of

(i) the time the employee first has a legally binding right to the payment and

(ii) the time the employee would have had to make an irrevocable deferral election, had such election been available to the employee.

For example, in the case of an employer who, on December 15, 2007, grants an employee a bonus in respect of services to be performed in 2008 that may not be reduced or eliminated in the unfettered discretion of the employer and that is payable at a later date (but not at a time when such payment would qualify as a short-term deferral), the employer must establish the time and form of payment on or before December 31, 2007 (i.e., the date on which the employee could have made the election to defer the bonus). The Acceleration of Payments With respect to elections made after December 31, 2007, 409A prohibits the acceleration of the time or schedule of deferred compensation payments, except in certain specified instances.

Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations provide that an employer may exercise discretion to cash out an employee’s entire deferred amount under a type of plan (using plan aggregation rules) any time that such amount is less than the Section 402(g) limit for that calendar year ($15,500 in 2007). The final regulations do not require that the employee experience a separation from service in order for the employer to cash out the employee’s benefit under the plan. The final regulations also increase the cash-out limitation from $10,000 to the Section 402(g) limit for the applicable calendar year.
  • The final regulations provide that a plan under which amounts are to be paid in installments may provide for immediate and non-discretionary payment of all remaining installments if the present value of the deferred amount to be paid in the remaining installments is less than an amount pre-specified in the plan at the time of deferral.
  • Note that, like the proposed regulations, the final regulations do not permit the acceleration of deferred compensation payments to avoid a violation of the “top-hat plan” rules of the Employee Retirement Income Security Act of 1974 (ERISA), such as where a plan participant falls outside of a select group of management or highly compensated employees.
  • After December 31, 2005, in order to terminate a nonqualified deferred compensation plan, other than in the context of a corporate dissolution, bankruptcy or change in control event, the final regulations require that

(i) the termination not be proximate to a downturn in the financial health of the employer,

(ii) all plans of the same type (using the plan aggregation rules) are terminated with respect to all employees,

(iii) no liquidated distributions are made within 12 months of the plan termination,

(iv) all payments under the plan are made within 24 months of the plan termination, and

(v) no new plans of the same type as the terminated plan are adopted in the three years (modified from five years in the proposed regulations) following the plan termination.

Time and Form of Payment

409A prohibits plans from permitting distributions of deferred compensation prior to the occurrence of one of the following:

(i) the employee’s separation from service,

(ii) the date the employee becomes disabled,

(iii) the date the employee dies,

(iv) a time or fixed schedule specified under the plan on the date of the deferral, (v) the date of a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of its assets, or (vi) the occurrence of an unforeseeable emergency.

Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations provide guidance on the structure of permitted distribution schedules. Payment schedules with fixed or objective formula limitations on the amount that will be paid during any particular period will meet the requirements of a fixed schedule, where the limitation is based on a fixed or nondiscretionary, objectively determinable formula limitation; where all of the factors relevant to the determination of such limit are beyond the control of the employer and not subject to any exercise of discretion by the employee. A formula may include a cap on each year’s distributions, either to an individual or to a group, provided that the plan includes a nondiscretionary, objectively determinable, method to allocate the required reductions, and the plan specifies the time and form of payment of any amount that will be paid after its original due date due to the application of such cap.

Acceleration of Payments

With respect to elections made after December 31, 2007, 409A prohibits the acceleration of the time or schedule of deferred compensation payments, except in certain specified instances.

Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations provide that an employer may exercise discretion to cash out an employee’s entire deferred amount under a type of plan (using plan aggregation rules) any time that such amount is less than the Section 402(g) limit for that calendar year ($15,500 in 2007). The final regulations do not require that the employee experience a separation from service in order for the employer to cash out the employee’s benefit under the plan. The final regulations also increase the cash-out limitation from $10,000 to the Section 402(g) limit for the applicable calendar year.
  • The final regulations provide that a plan under which amounts are to be paid in installments may provide for immediate and non-discretionary payment of all remaining installments if the present value of the deferred amount to be paid in the remaining installments is less than an amount pre-specified in the plan at the time of deferral.
  • Note that, like the proposed regulations, the final regulations do not permit the acceleration of deferred compensation payments to avoid a violation of the “top-hat plan” rules of the Employee Retirement Income Security Act of 1974 (ERISA), such as where a plan participant falls outside of a select group of management or highly compensated employees.
  • After December 31, 2005, in order to terminate a nonqualified deferred compensation plan, other than in the context of a corporate dissolution, bankruptcy or change in control event, the final regulations require that (i) the termination not be proximate to a downturn in the financial health of the employer, (ii) all plans of the same type (using the plan aggregation rules) are terminated with respect to all employees, (iii) no liquidated distributions are made within 12 months of the plan termination, (iv) all payments under the plan are made within 24 months of the plan termination, and (v) no new plans of the same type as the terminated plan are adopted in the three years (modified from five years in the proposed regulations) following the plan termination.

Time and Form of Payment

409A prohibits plans from permitting distributions of deferred compensation prior to the occurrence of one of the following:

(i) the employee’s separation from service,

(ii) the date the employee becomes disabled,

(iii) the date the employee dies,

(iv) a time or fixed schedule specified under the plan on the date of the deferral,

(v) the date of a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of its assets, or (vi) the occurrence of an unforeseeable emergency.

Noted Changes/Clarifications from Proposed Regulations:

  • The final regulations provide guidance on the structure of permitted distribution schedules. Payment schedules with fixed or objective formula limitations on the amount that will be paid during any particular period will meet the requirements of a fixed schedule, where the limitation is based on a fixed or nondiscretionary, objectively determinable formula limitation; where all of the factors relevant to the determination of such limit are beyond the control of the employer and not subject to any exercise of discretion by the employee. A formula may include a cap on each year’s distributions, either to an individual or to a group, provided that the plan includes a nondiscretionary, objectively determinable, method to allocate the required reductions, and the plan specifies the time and form of payment of any amount that will be paid after its original due date due to the application of such cap.
  • The final regulations provide extensive guidance on when an employee (or a consultant) will be treated as having separated from service.

An employee separates from service if the employee dies, retires or otherwise has a termination of employment with his or her employer. Whether an employee has experienced a termination of employment is determined based on whether the facts and circumstances indicate that the employer and the employee reasonably anticipated that no further services would be performed after a certain date or that the level of bona-fide services the employee would perform after that date would permanently decrease to no more than 20 percent of their average level in the preceding 36-month period. A separation from service is presumed not to occur in the event of a purported termination of employment if the employee continues to provide services to the employer (e.g., as a consultant) at a level that is 50 percent or more of the employee’s average level of services for the preceding 36 months. Conversely, a separation from service is presumed to occur in the event of a purported continuation of employment of an employee, if the employee’s services are reduced to a level that is 20 percent or less of the average level of the employee’s services during the preceding 36 months. A leave of absence (other than due to disability) for more than six months is deemed to be a separation from service unless the employee has a right to reemployment. In applying the distribution rules for separation from service, all affiliates in the same controlled group are generally treated as a single employer (generally utilizing a 50 percent common ownership requirement, although the plan may specify an alternative common ownership requirement as low as 20 percent,

if use of such requirement is based on legitimate business criteria, or as high as 80 percent). In the event of a sale of all or substantially all of an employer’s assets, the buyer and the seller may specify at the closing date whether transferring employees will be treated as having incurred a separation from service.

  • Deferred compensation payments upon the separation from service of a “key employee” of a company that has publicly traded stock may not be made before the date that is six months after the date of separation from service. The final regulations provide alternative methods for implementing the required delay. For example, plans may provide that payments to all employees will be delayed for six months following separation from service. A plan may also provide that the six-month delay will be applicable to an objectively determinable non-elective group of employees, designed to include all key employees, provided that such group does not exceed 200 employees.
  • It is not sufficient for a plan to state that a payment will be made “as soon as administratively practicable” after a payment event, unless the payment is restricted to a single tax year or no more than 90 days following the payment event (as long as the employee does not control the tax year of payment). This clarification was made to the final regulations to address issues where payments could be made any time during a specified period following a payment event that covers more than one taxable year.
  • The final regulations clarify that only one time and form of payment may be designated for each permissible payment event, subject to limited exceptions. A plan may provide for a different time and form of payment depending upon whether a permissible payment event occurs on or before one specified date, e.g., payment of a lump sum on the first day of the month following separation from service before age 55, but five annual installments beginning on the first day of the month following separation from service on or after age 55. In the case of payments made upon an employee’s separation from service, a plan may also permit alternative times and forms of payments depending on whether the employee’s separation from service occurs

(i) within two years of a change in control event; and/or

(ii) before or after a specified date, or before or after a combination of a specified date and

period of service (e.g., age plus years of service equals 65). The proposed regulations only permitted alternative times and forms of payments in the event a payment event occurred before or after a specified date. The noted provision provides increased flexibility for special payment provisions in severance agreements.

  • A payment is treated as made upon the date specified under a plan if the payment is made on such date or any later date in the calendar year, or, if later, by the 15th day of the third calendar month following the date specified in the plan and if the employee cannot control the year of payment. The final regulations provide that amounts may be paid before a date specified under the plan if the payment is made no earlier than 30 days prior to the designated payment date and the employee does not designate the taxable year of payment.
  • If the calculation of an amount is not administratively practicable due to events beyond the employee’s control, or if making the payment would jeopardize the employer’s ability to continue as a going concern, the payment will be treated as made on the date specified under the plan if the payment is made during the first calendar year in which the payment is administratively practicable or the making of the payment would not have that effect, as applicable.

Stock-Based Plans

Certain types of stock-based compensation are subject to 409A, while other types of stock-based compensation may be structured to be excluded from 409A.

Noted Changes/Clarifications from Proposed Regulations:

  • The preamble to the final regulations states, definitively, that the ability to defer gain upon the exercise of a stock option is incompatible with, and impermissible under, 409A (unless the gain is deferred in accordance with 409A at the time that the legally binding right to the stock option arose).
  • The final regulations provide that if a modification results in the disqualification of a statutory stock option, that option will only be subject to 409A if such modification would have been treated as a new grant for 409A purposes if the incentive stock option had been a non-statutory stock option at its original grant date. In that case, the modification giving rise to this disqualification of the option may be treated as the grant of a new option for purposes of 409A. For example, the modification of an incentive stock option to give an employee the right to elect to receive cash, instead of stock, upon exercise of the option, will disqualify the option as an incentive stock option, but will generally not subject the option to 409A.
  • The final regulations provide more flexible rules regarding the type of stock that may be granted pursuant to options and SARs that are not subject to 409A, as well as the types of issuers that may grant such stock. The deferred compensation exclusion for non-statutory stock options and SARs is only available if the stock subject to the options or SARs: (i) is issued by the corporation to whom the employee is providing services and any corporation above that corporation in a direct chain of corporations that all have a controlling interest in one another (a controlling interest is generally defined as a 50 percent common ownership requirement, or a 20 percent common ownership requirement if the grant is based on legitimate business criteria), (ii) is common stock for purposes of Section 305 of the Internal Revenue Code, and (iii) does not have any preferential rights (other than preferential rights as to distributions of service-recipient stock and distributions in liquidation of the issuer). However, stock subject to options and SARs granted on or before April 10, 2007, that was designated, under a reasonable good-faith interpretation, as service-recipient stock will be deemed to be service-recipient stock for purposes of 409A.
  • The final regulations clarify that a private corporation can use one valuation method to determine the exercise price of an option and another valuation method to establish the cash period of service (e.g., age plus years of service equals 65). The proposed regulations only permitted alternative times and forms of payments in the event a payment event occurred before or after a specified date. The noted provision provides increased flexibility for special payment provisions in severance agreements.
  • A payment is treated as made upon the date specified under a plan if the payment is made on such date or any later date in the calendar year, or, if later, by the 15th day of the third calendar month following the date specified in the plan and if the employee cannot control the year of payment. The final regulations provide that amounts may be paid before a date specified under the plan if the payment is made no earlier than 30 days prior to the designated payment date and the employee does not designate the taxable year of payment.
  • If the calculation of an amount is not administratively practicable due to events beyond the employee’s control, or if making the payment would jeopardize the employer’s ability to continue as a going concern, the payment will be treated as made on the date specified under the plan if the payment is made during the first calendar year in which the payment is administratively practicable or the making of the payment would not have that effect, as applicable.

Stock-Based Plans

Certain types of stock-based compensation are subject to 409A, while other types of stock-based compensation may be structured to be excluded from 409A.

Noted Changes/Clarifications from Proposed Regulations:

  • The preamble to the final regulations states, definitively, that the ability to defer gain upon the exercise of a stock option is incompatible with, and impermissible under, 409A (unless the gain is deferred in accordance with 409A at the time that the legally binding right to the stock option arose).
  • The final regulations provide that if a modification results in the disqualification of a statutory stock option, that option will only be subject to 409A if such modification would have been treated as a new grant for 409A purposes if the incentive stock option had been a non-statutory stock option at its original grant date. In that case, the modification giving rise to this disqualification of the option may be treated as the grant of a new option for purposes of 409A. For example, the modification of an incentive stock option to give an employee the right to elect to receive cash, instead of stock, upon exercise of the option, will disqualify the option as an incentive stock option, but will generally not subject the option to 409A.
  • The final regulations provide more flexible rules regarding the type of stock that may be granted pursuant to options and SARs that are not subject to 409A, as well as the types of issuers that may grant such stock. The deferred compensation exclusion for non-statutory stock options and SARs is only available if the stock subject to the options or SARs:

(i) is issued by the corporation to whom the employee is providing services and any corporation above that corporation in a direct chain of corporations that all have a controlling interest in one another (a controlling interest is generally defined as a 50 percent common ownership requirement, or a 20 percent common ownership requirement if the grant is based on legitimate business criteria),

(ii) is common stock for purposes of Section 305 of the Internal Revenue Code, and

(iii) does not have any preferential rights (other than preferential rights as to distributions of service-recipient stock and distributions in liquidation of the issuer). However, stock subject to options and SARs granted on or before April 10, 2007, that was designated, under a reasonable good-faith interpretation, as service-recipient stock will be deemed to be service-recipient stock for purposes of 409A.

  • The final regulations clarify that a private corporation can use one valuation method to determine the exercise price of an option and another valuation method to establish the cash payment upon exercise; however, once used, the valuation method may not be retroactively altered.
  • The final regulations clarify that it is not necessary that the fair market value be determined by an independent appraiser in order to be reasonable.
  • The final regulations significantly liberalize the circumstances under which the term of an option may be extended. For example, the final regulations permit (i) any extension of the exercise period of an underwater option and (ii) the extension of the period during which a former employee may exercise his or her option following termination of employment to the earlier of ten years from the option grant date or the maximum exercise period available under the terms of the option.
  • The final regulations incorporate several definitions from the rules applicable to incentive stock options, such as “date of grant,” “exercise price,” “stock,” and “transfer.” The date of grant of an option or SAR is the date when all necessary corporate action is taken to create a legally binding right to the option or SAR. All necessary corporate action is considered taken when the maximum number of shares and the minimum exercise price are fixed and determinable and the class of underlying stock and the recipient are identified. An unreasonable delay in the notification of the recipient of the grant of the option or SAR, is an indication that the grant date is the subsequent date on which notice is given.

Rules Affecting Separation Pay Plans

The final regulations generally adopt the exemptions relating to separation pay plans that were set forth in the proposed regulations, but the final regulations expand the scope of the exemptions. As a result, employers will find it much easier to structure separation pay plans to be exempt from, or comply with, 409A.

  • A separation pay plan where severance is paid upon an actual involuntary separation from service or pursuant to a “window program” is exempt from 409A if the entire amount paid under such plan to any employee does not exceed two times the employee’s compensation for the year prior to separation (or, if less, two times the annual compensation limit then applicable to tax-qualified plans, which limit is $225,000 for 2007) and is paid no later than December 31 of the second calendar year following the calendar year in which the employee’s separation from service occurs. Notably, this exclusion will apply to payments up to the limit described above, even where the entire amount of the separation payment exceeds the limit. As a result, this exception can be used to deliver compensation, up to the limit specified above, to a key employee to whom the six-month delay in payments applies, even during the applicable six-month delay period.
  • The final regulations clarify that separation pay does not include amounts payable upon separation from service that could be received without the employee’s separation from service (that is, amounts that are also payable upon a change in control, as a result of an unforeseeable emergency or on a certain date). Amounts paid upon separation from service in substitution for, or replacement of, amounts deferred under a separate plan that would have otherwise been forfeited upon a separation from service are deemed to be paid under the separate plan (and, as a result, the vesting and payment of such amounts upon a separation from service may be an impermissible acceleration)
  • A right to payment upon a separation from service for “good reason” may be treated as a right to payment upon an involuntary separation from service (see next bullet) and, if so, that payment right may be treated as subject to a substantial risk of forfeiture until the employee actually terminates employment due to such good-reason condition. As a result, taxpayers can use good-reason definitions in separation pay arrangements, and retain the potential to have amounts paid thereunder excluded from the definition of nonqualified deferred compensation, either because such amounts service that do not exceed the Section 402(g) limit ($15,500 in 2007) in the aggregate are not subject to 409A. The final regulations also include new exemptions for indemnifications for legal expenses, liability insurance, legal settlements and educational benefits to the employee.
  • Reimbursement or in-kind benefit plans will be deemed to provide payments at a specified time or on a fixed schedule, in compliance with the payment event rules of 409A, if the plan provides for reimbursements of, or in-kind benefits with respect to, expenses that are objectively determinable and nondiscretionary benefits during an objectively prescribed period, and the amount reimbursable in one tax year does not affect the amount reimbursable in another year and the reimbursement payment is made by the end of the employee’s taxable year following the taxable year in which the expense is incurred. Such benefits may not be subject to liquidation or exchange for another benefit. For example, an agreement to provide reimbursement for up to $30,000 in club dues over three years would not comply with 409A, but an agreement to provide club dues for up to $10,000 per year for three years would generally comply with 409A. Medical plans may include lifetime medical limits or other maximum benefit levels.
  • Tax gross-up payments are also considered to provide for distributions at a specified time or on a fixed schedule, if the payments are made no later than the end of the taxable year following the taxable year in which the related taxes are paid to the government. Nonqualified Deferred Compensation Plans Linked to Qualified Plans

The final regulations provide certain rules with respect to the linking of:

(i) deferral elections and/or formulas for benefit accruals under a tax-qualified retirement plan and a nonqualified deferred compensation plan; and

(ii) the time and form of benefit payment elections under a tax-qualified retirement plan and a nonqualified deferred compensation plan.

  • The final regulations permit employers to make matching contributions to nonqualified deferred compensation plans in respect of amounts contributed to the nonqualified plans due to application of IRS contribution limitations on the related tax-qualified plan.
  • The preamble to the final regulations states that a linked arrangement commonly referred to as a “spill-over” arrangement (whereby a highly compensated employee is permitted to make his or her elective deferred compensation contributions first to the tax-qualified retirement plan and then, once such contributions reach the maximum annual 401(k) contribution limit and/or the maximum amount that would not cause such plan to fail the applicable non-discrimination tests for the year, to the nonqualified deferred compensation plan) will not comply with 409A.

Conclusion

Employers should review all of their compensation arrangements to determine whether such arrangements are subject to 409A. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should (i) maintain the plans in operational compliance with a reasonable, good-faith interpretation of 409A at all times up through December 31, 2007, (ii) adopt amendments to bring the plans into full administrative compliance with 409A by December 31, 2007 and (iii) ensure that the plans are in writing by December 31, 2007. Failure to take such actions may result in material adverse tax consequences to employees entitled to compensation under such plans.